Beating a dead horse: cash out 401k to pay student loans

[vivophoenix]

One thing that always confuses me is when people talk about cashing out their 401k to pay debts.


Everyone screams this a terrible idea for the following reasons:

1) the 10% penalty
2) OMG you'll have to pay taxes
3) loss of future earnings
4) the rate of return inst worth it
5) their wise uncle told them not to do so
6) the tax deduction, its amazing!


but it doesn't make sense to me for the following reason:

1) if its a one time 10% penalty and that 10% is cheaper than 7% apr for 15 years, it seems like the one time penalty makes sense

2) you're paying tax already to make those loan payments. so you either pay the tax every year for 15 years, or pay the one time tax on the cash out

 true that might become an issue if it bumps you up in tax bracket. but if that was the case one could easily do the math to balance it out over a few years. or even decide in the year you are going to cash your 401k in, to max out your 401k and lower your bracket that way

3) you can get a return of the 7% intrest on your loans for 15 years, after the loans are gone, max out your 401k earlier and put aside the left over money into investments and still make the return each year that i would have made on the old 401k .  or i can make student loan payments and put into my 401 k, but smaller and over more time.   

4) what if that oen time 10% is way less than the interest over the life of the loan?


5) ignore him, he also was the strange uncle that never got married and lived in that house in the woods

6) once you make over 60k that goes away, and is that 2500 max a year for 15 years(hopefully) really worth it? esp if you pay way more than 2500 in interest each year?



for example :

if I had a loan that was 60000 and the interest rate was 7%, for 15 years.

is it worth it to pay it every month or does the math make sense to cash in 401k for like 20,000 and then continue payments as normal

the penalty is 2000
taxes 6000 if you are in the 25% bracket and 5% state tax
which would leave you with a lump sum payment of ~12000

i am calculating just doing that one lump sum payment will save you ~$9000 over the life of the loan.
add in the time saved paying the loan that is that much more time to put the original loan payment towards investing and assume you take that 9000 saved and invest that

some arguments are the idea that i will never get that time back, however will four years cashed out 401k really outweigh the next years, especially if this allows me to increase the latter year contributions( aka the original student loan payment)?

i would like some feedback, and not the 'oh throw every dime at the loan and the 401K' . I would like  feedback on the math/reasoning

[PloddingInsight]

I ran a spreadsheet simulation assuming the following:

60,000 loan at 7% for 15 years so payments are $539.30
401k balance of 20k.
No future 401k contributions (to keep it simple).
Stocks earn 7% a year.

If you cash out the 401k, you get $13,000 after 25% taxes and 10% fees.  If you reduce the debt by that much and continue the same regular payments, you pay off the debt in about 10.2 years.  At that point, your debt and 401k are both at zero.  So ignoring at future savings during those 10.2 years, you essentially achieve a zero net worth at that time.

Then I change the spreadsheet to keep the money in the 401k.  Let's look at the same point in time (10.2 years out) to see if you are better or worse off.

Remaining Debt:  $26,472
401k Balance: $40,663

This looks like a positive net worth, but remember you still pay taxes and fees if you want to spend the money.  If we withdrew all the money in the 401k at this time, you'd end up with $26,430, after taxes and fees, which combined with the debt is pretty much exactly zero.  (This is because the stock returns in my simulation match the interest you're paying exactly.)

So if you are going to pay the early withdrawal penalties, it doesn't matter when you do it.  But if you are going to keep saving for retirement, and avoid the early withdrawal fees entirely, (and that should be your plan) then you are unambiguously better off keeping the money in your 401k.

Having the debt probably makes a bit more desperate to cut your spending too, so there might be additional benefit in terms of motivation.

[vivophoenix]

i get it

so if my math is correct. in the first scenario  at the end of 15 years if you started applying you loan payments toward investments you will be net ~27k


in the second at year 15 your loan balance would be zero but your 401k balance would be ~53k. and after taxes and peanalty it would be `37


thank you very much for your help !

[PloddingInsight]

EDIT:  I guess you edited your post above but here's my response to your question about what things look like at the 15 year point.  END EDIT.

Sure.  At 15 years, if you didn't withdraw anything from the 401k, you would have a portfolio worth $56,978.

If you withdraw the $20k and maintain a zero balance for 10.2 years, and then contribute $539.30/mo until year 15, you have a balance of $37,095.  But you'll have more than that because of the tax benefit.  You have to earn $719.07 to pay 25% taxes and then make the debt payment.  If you contribute the whole $719.07/mo during that time you would have $49,459 at the end.

So the benefit of keeping the 401k is about $7500 at the 15 year mark.

[okashira]

Facepalm. No MMM'r should be keeping a 7% interest student loan for 15 years. Your point is moot.
Keep the 401k where it is.

[PloddingInsight]

Facepalm. No MMM'r should be keeping a 7% interest student loan for 15 years. Your point is moot.
Keep the 401k where it is.

No, OP's question was completely valid.  The issue is whether cashing out a 401k to pay down debt is a step forward or a step backward.  Don't you think MMM would advocate running the numbers to see what choice offers the best outcome?

[vivophoenix]

oh thank you very much for reminding me of the tax benefit. I had included that in some math previous to this post. that also made me seem to think this idea inst as crazy as everyone thinks. all the other articles i read always make this seem like a catastrophic loss to future earnings and you will die in  a cardboard box.

[vivophoenix]

okashira you did exactly what i  asked posters not to do. everyone does not have cash sitting around to super attack loans. i dont need emotional judgements, i need facts

[Angie55]

Yes, but doing a comparison over 15 years really would be inaccurate. Maybe you don't have the cash to payoff immediately but you could payoff over a shorter time frame say 5-7 years or less with minimal extra to principal each month. Then, the 10% penalty on 401k withdrawal makes a larger effect because its spread over a shorter amount of time.

I would not recommend taking out of your 401k. I would however, reduce the amount you are contributing now and use that to snowball the loan.

As an aside, I hate when people count on the interest deduction as if it makes a noticeable difference...... Typically big loans = big salary so the deduction gets phased out. Also, big loans = interest WAY more than 2500 a year. Especially if you are married.

[vivophoenix]

Hey Angie55,


I dont understand your point about the shorter loan period exaggerating the 10% penalty.

in the previous calculations there are no addition contributions to the 401k. i am not discussing snowballing. i am only looking at early 401k withdrawal.

[okashira]

okashira you did exactly what i  asked posters not to do. everyone does not have cash sitting around to super attack loans. i dont need emotional judgements, i need facts

I've run more finance calculation scenarios then you could shake a stick at. I don't need to to run it.
This is just a bad idea.

Get some credit cards with a 0% 0% fee balance transfer and juggle them that way. You could keep the ball rolling for years with good credit.

[vivophoenix]

then if youve run them why dont you share them with me?

I asked a question in hopes of leaning more, and the only thing you have done was make judgmental comments. i dont want to be told what to do , i want to learn.

what do you mean use crdit cards to juggle the balance?

[Angie55]

Okay here's my calculations... Probably not exact but makes sense to me. I tend to get things wrong the first time around so let me know if something is backwards.

Assumptions:
15% fed tax bracket + 5% state tax
30k student loan balance at 7%
7% gains on 401k.
There is $0 extra each month so no extra payments are accounted for.

Scenario 1: Pay off 30k student loans with 401k. You would need to have taxes and penalty there making it a balance of 42850 to payoff the loan. Use the 270/month (325/mo pretax) payment to pay back monthly into your 401k (3900/yr). With 7% returns your 401k balance will be 98003.

Scenario 2: Keep the 401k intact with a starting balance of 42850, pay off your loans at min payments of 270/mo, pay nothing extra into 401k for 15 years. . The interest rate is 7% but because of the interest deduction (20% total taxes) it is effectively 5.6%. At the end of 15 years, with 7% returns, the 401k balance is 122,097. Assuming you put the tax savings back into the loan, you will pay it off in 158 months vs. 180 (22 mos / 2 years early. You can add the 323/month to your 401k for the last two years and gain interest on it for another 8073. The total amount in your 401k at that point is then 130170.

The 10% penalty is costing you. Of course this all changes depending on your salary, your expected retirement tax bracket, and how much extra cash you have each month.

[vivophoenix]

thanks Angie55!


that was very helpful!

[Cheddar Stacker]

vivophoenix, welcome to the forum. Some good responses already, but I wanted to add another option to the mix for your consideration. Have you thought about a 401k loan?

Pros:
Interest is around 4-5%, plus maybe $25-50/year fee.
Interest is paid to yourself within the 401k, not paid to a bank.
It acts as a bond in your 401k (fixed interest, guaranteed return on investment).
You don't have to get approval.

Cons:
If you get fired/quit you have to either pay it back in full or withdraw the outstanding balance (not a problem for you if you're already contemplating this anyway).
You can only take out the lesser of $50k or 50% of your 401k balance.
It takes away from your other 401k investments pool, so there's an opportunity cost since that money isn't invested.
You pay it back with post-tax money.
You might not be able to contribute to the 401k while the loan is outstanding (I was able to, all plans are different).

They're not for everyone, but I've used this for investment purposes and it worked very well. Not all employers offer them, so check your plan documents. Let me know if you have questions.

[vivophoenix]

I would,  but my current employer plan seems to not offer them. I currently have an old 401k with a  previous employer, a 401k Roth , and some normal savings. I used round numbers for examples to calculate with. however the amount of my student loan debt dwarfs my retirement savings so much that I wouldn't wipe it out. it would just result in mildly lowering my monthly payment. my hope is to be able to consolidate my loans one day. that is why i was considering more extreme measures. i wish i owed only 30k :/

also the pay back with post tax money idea, is misleading: any debt you pay would be with post tax money as well.

[Cheddar Stacker]

also the pay back with post tax money idea, is misleading: any debt you pay would be with post tax money as well.

Agreed. It feels different than other debts though since it's a paycheck W/H rather than a check you write.

Good luck with your efforts. I wouldn't cash out, but to each their own.

I guess if cashing out some to pay off your highest loans in order to consolidate the rest could be beneficial. Like the sum is greater than the parts in a way. I don't know, you'd have to provide more details or run the numbers yourself.

Don't forget that any 401k draw adds to your AGI which affects other things on your tax return. It's not just the 25% tax and the 10% penalty on the draw, it's the loss of other deductions or the affect on the rest of your return. I think you mentioned the SL interest deduction phase-out which is one example, but there are many others that are affected by AGI or MAGI so be careful and run all the numbers in the taxcaster.

[okashira]

then if youve run them why dont you share them with me?

I asked a question in hopes of leaning more, and the only thing you have done was make judgmental comments. i dont want to be told what to do , i want to learn.

what do you mean use crdit cards to juggle the balance?

I wouldn't post this on any finance forum, but I will here (there is a trick involved.)
Note, this is potentially a dangerous financial method if you cannot maintain employment, good credit and maintain discipline in the process. I will not be responsible for it messing up your finances in the future, or if you end up in jail if you try to discharge CC debt in bankruptcy on money that originated from a student loan.

Sign up for a credit card that offers 0% fee, 0% interest balance transfer. Example:
https://creditcards.chase.com/slate-credit-card/learnmore-apply

That's 15 months 0% interest.
They are designed to transfer a CC balance, not a student loan, so you have to find a way to cash it out.
First, you could try entering your account number (student loan) directly on the CC application.
If a no go, then there are other ways, such as buying visa prepaid debit cards in stores with the CC, and then converting them to cash.
The final go to is a credit card with a 0% cash advance fee. You transfer a balance from this card, then boom use a cash advance to get back to zero. Zero interest. If someone really needs to do this, PM me.

I have a chase slate and was able to get a $12000 limit, could be more with negotiation. That's 1200 in saved interest at 7.5% over 15 mo.

Now that you have a CC balance, the next one is easy. After 14 months, find another card and transfer it over.


All in all, this is a poor replacement for simply TREATING THAT 7.5% INTEREST STUDENT LOAN DEBT LIKE YOUR FUCKING HAIR IS ON FIRE, and paying it off in much less then 15 years.

[Angie55]

In regards to utilizing 0% credit cards... I did this with my husband's private student loan. It was around 40k @ 9% interest. We had one of citicards balance transfer offers where after you initiate a balance transfer any charges on the card were also 0% for the length of the balance transfer. We did a small balance transfer for $100 then used ChargeSmart to payoff the student loan.

You can use ChargeSmart to make payments to your loans with a maximum of either $2500 or $5000 payments (per day I think). The fee varies between 2-3% depending on the loan servicer and the amount you pay. My fees were around 2.9% but I also received credit card rewards of 1%.

Due to the worried tone in your posts this probably won't work for your specific situation. But it may for others. I did this in 2012 so I'm not even positive the "no interest on purchases" offers still exist. They certainly would if you apply to new credit cards though.  Maybe get one with 1.5-2% rewards.

[vivophoenix]

oh so what it sounds like if i under stand properly you would put the loan on the card. then pay it off during the 0% apr. and it sounds like its most helpful if the line of credit is large enough to cover your entire loan. is that correct?

[ampersand]

... Or if you aren't able to pay it off, you jump it to another 0% interest card.

What okashiro alludes to but doesn't say outright is that this can cause serious issues if you were to go into bankruptcy. Currently it is not allowed to refinance student loans at lower rates. Also, student loans cannot be gotten rid of by bankruptcy. Should you default and try to discharge your student loans via your cc debt it could have legal ramifications.... Makes me wish I was in the student loan business.

I'm hesitant to ask but likely someone here knows. What are the current rates on unsecured debt via peer 2 peer lending? At 7.5% maybe that's a feasible way to decrease interest.


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[Joel]

On average, your 401k would return around the same percentage as you would save in interest. That's before student loan interest deduction, any other tax phaseouts caused by the additional income in the current year, and the 10% penalty for early 401k withdrawal.